Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

Will the Music Industry End Pandora’s Business Model?

Forcing Pandora into a subscription-based model too soon could hurt the business.

For investors in streaming-radio provider Pandora(NYSE:P), it's been a tough run since its IPO. Shares of the company are barely higher than its IPO price of $16 per share, while the Nasdaq is up 85% during that period. On Friday, the stock climbed higher than the $16 mark as unconfirmed and unsubstantiated rumors about a buyout continue to swirl throughout the blogosphere.

For investors, Pandora has had problems scaling its business. While concerns about content acquisition costs have been addressed by the company growing total revenue at a faster clip than content acquisition costs, the company has embarked on a rather ambitious sales and marketing push to grow revenue. Between those two line items, the company is having problems scaling out of those two costs. For additional perspective, see the table below.

Fiscal Year

2012

2013

2014

Content Acquisition Costs

$248 million

$342 million

$446 million

Sales and Marketing Costs

$101 million

$182 million

$277 million

Total Revenue

$410 million

$637 million

$920 million

Content Acquisition and Sales and Marketing Cost %

83.4%

82.5%

78.5%

Source: Pandora's historical detailed financials.

However, right now, scalability is not even the biggest concern with Pandora's business model. A recent article from The Wall Street Journal points out Pandora's biggest problem -- the music industry no longer wants it to succeed in its current form.

Supplier power is strongIn an article entitled, "Era of Free Digital Music Wanes" (subscription required), it appears the music industry is rethinking the value proposition of the fremium business model of streaming-based services. As a matter of fact, an unnamed major-label exec was quoted as saying his label made a "mistake" to allow licensees offer on-demand listening features for free. This comes after years of artists complaining about unfair payouts from streaming-based services -- most famously, Taylor Swift recently pulling her catalog off of Spotify.

Major labels are not as powerful as they once were, but they're still a powerful supplier -- and there are no substitute goods for Pandora as far as content goes. In addition, the music industry is an entrenched oligopoly with only three major labels. Therefore, it's a strong possibility that, once one pulls its catalog, the others will, as well, acting in concert to preserve their business interests.

Ironically, the failure of the music industry to adjust to digital downloads, rather than a hard copy, led to Apple being able to exploit their myopia for huge profits with iTunes and the iPod. After the music industry's huge strategic error of losing out on the ability to shape the digital download space to its benefit, you'd assume it wouldn't have conceded the streaming market -- but you'd be wrong.

Want to listen to music? Pay for it!It's not like the music industry wants Pandora, Spotify, et al., to fail; it just wants streaming-based services to limit the fremium model. Where Pandora and Spotify look to monetize the free streaming side with ad-based revenue, music executives appear to want these companies to treat free streaming as a trial period in order to induce users into subscriptions. Obviously, that's more lucrative for Pandora, as revenue per 1,000 listener hours is nearly $77 dollars for a subscriber, and $42 for an ad-based user.

However, there's just no guarantee Pandora can entice enough users to make the jump. Last fiscal year, Pandora reported only 20.4% of its revenue from subscriptions. If the music industry wants Pandora to try to transition all users into subscribers, it could wreak havoc in its top line.

But that's what it appears the music labels want, according to another label executive: "If they're not serious about having a paid tier and improving monetization, we're going to be less interested in working with them." This could all be negotiation bluster; but in the event labels withhold content from Pandora, the investment could suffer greatly.

Author

Inspired by the idea of "making your money work for you" at a young age, mostly because he was a lazy child, Jamal parlayed that inspiration into a love of the psychology of markets, competitive advantages, and thematic investing. He later shrug off that laziness, with a career that included stints as a mortgage trainer, a financial advisor, a Sr. Investments Communications Specialist, and a stockbroker. Jamal graduated from George Mason University with a bachelors of science in finance, American University with a masters in finance, and is a CFA charterholder.